As I mentioned in this morning’s Portfolio Update, there are two reasons why our portfolio risk curve has deflated somewhat since we opened our second November position even though it should be benefiting from time-decay. Well, it has benefited from time-decay—just not enough to offset the effects of changing implied volatility.
A big difference between iron condors and calendar spreads is that we’re selling the differential in time decay between two expirations rather than two strikes at the same expiration; therefore, our positions are affected by both IV and volatility term structure. Because changes in implied volatility affect the value of far-month options more than that of nearer-month ones, an overall drop in IV works against our trades; however, what we tend to be most concerned about is back-month IV.
Volatility and Calendar Spreads
We may have to wait until 4:00 pm on expiration Friday, but the extrinsic value of our short, front-month contracts will always decay to virtually zero (pin risk is the exception—not to mention gamma risk—but those are topics for another day). What we also need, though, is for the long, back-month contracts to retain their value. We often just let the long legs of one or both sides of an iron condor expire worthless, but we can’t do that with calendar spreads. Whenever we close the short side—a week, two weeks, or two days before expiration—the long contracts still have a lot of time premium that can steadily drain off our profit if don’t cash it in when we exit the position. And implied volatility is the primary factor affecting that remaining time value on any given day.
Our main concern with front-month IV is volatility term structure (the relationship between the implied volatility for options expiring in different months). The more vol is skewed toward the back month in a calendar spread, the more the spread costs—so when IV shifts in the direction of the near-term contracts when we’re already in a trade, we get the opposite effect: the current value of our position goes down. Over the past two weeks, we’ve been hurt by both falling IV and a forward shift in vol skew.
Here and Now
The chart of VXV below represents the implied volatility of longer-term SPX options. The index is a weighted average that attempts to gauge the volatility of S&P index options three months from the current date, and thus is a very imprecise proxy for the IV of our December SPY long position. Nevertheless, the path of VXV over the past two weeks does convey the point that market perception of risk heading into the end of the year, and longer-dated option IV along with it, has fallen significantly.
Over the same period, traders’ estimation of risk for the next month, represented by the VIX, has stayed about the same. The VIX has swung up and down through about a 7.5% range, but it ended today a hair above where it closed on October 12. The chart below plots the ratio of VIX to VXV, which clearly shows why our current unrealized P/L isn’t exactly where we’d like it to be.
But what does that really mean for the risk/reward proposition of our portfolio? The Calendar Options strategy takes volatility risk into consideration from beginning to end. It’s part of what tells us when to open a position, how to structure it, and how to manage it throughout its duration. The only aspect in which our risk increases from changes in volatility skew, per se, is that it can put us closer to our 20%–25% loss-level risk-management threshold and force a premature adjustment or exit…and that’s something we’ve seen a lot less of since refining the strategy in April.
So to wrap up, losses from adverse changes in volatility skew typically are temporary, or at least not sufficient to significantly damage the long-term risk/reward of our strategy—as long as we’re disciplined in managing all facets of risk in accordance with the strategy rules, and trade the strategy consistently month to month, every single month.